Budget Cuts in Europe: Meet the “Virtuosi” and the “Laggards”

Who are the Laggards and who the Virtuosi in the current wave of budget cuts in Europe? What lesson can we draw from the evidence? How should we assess the distribution of budget cuts among European countries? Many observers have focused on country specific issues such as debt sustainability, see for example the recent IMF Fiscal Monitor 2010, or on the likely effects of budgets cut on the recovery. The issue of the European distribution of cuts , however, has not been addressed. This is hardly surprising: unlike in the US, there is no European federal budget, and the Growth and Stability pact has nothing to say on the distribution of the burden of adjustment among member countries. Yet as Europe gets more and more integrated and fiscal policy increasingly centralized, these questions are poised to become more relevant.

In a previous article (Manasse 2010) I have argued that the present allocation of budget cuts in Europe makes sense from euro-wide viewpoint: the planned consolidations for 2010-15 tend to be larger for countries with higher public debt/GDP ratios and larger primary fiscal deficits, as required by the need to address solvency issues; also, countries with larger current account deficits have planned (ceteris paribus) tougher cuts, as required for correcting imbalances within Europe. The snag is that cuts tend to be larger where unemployment is higher, which does not bode well for the recovery in Europe. The question I address here is: which country is doing too little or too much from an European perspective?

Laggards and Virtuosi

The first column in Table 1 shows the planned cumulative budget cuts for 2010-15 for countries in the Euro- zone and the UK (source: CESIFO). On average (last row), the fiscal consolidation effort in Europe is substantial, 4.2 point of the area’s GDP, and it is mostly concentrated in 2011-13. It woud be misleading, however, to compare each country’s effort with the European (weighted) average, and to label a country a “Laggard” or “Virtuoso” depending on cuts being below or above the average. By doing so, one would (wrongly) conclude that Germany and the Netherlands are a “Laggards” (which obviously they aren’t)!

We have at least to consider where each country stands with respect to public debt and the primary balance. Take Italy, for example. It accounts for 14.2% of the European GDP (Euro area plus UK, last column of Table 1), but is responsible for almost 24% of the outstanding public debt in Europe (second column). Presumably, its adjustment shoud reflect this and exceed the actual meagre 1.6% of GDP (first column). However, the primary balance in Italy in 2010 (at -1% of GDP) is more than 4 points above the European (weighted) average, see the third colun in the table. On that count, Italy should adjust less. So, how can we put all this information together? Clearly, we need “European” benchmark.

I construct such a benchmanrk by way of a simple cross-section regression[1]. In other words, I ask: how does the adjustment of country A, say, compare with the adjustment that the “average European ” would have chosen had it experienced the same economic fundamentals of A (primary balance, debt ratio, overvaluation of the real exchange rate, current account balance and unemployment rate) in 2009? [2] The results for two exercises (the first excluding and the second including[3] Greece in constructing the benchmark) are illustrated in Figure 1.

Source: author’s calculations

A positive (negative) bar indicates the percentage GDP points by which a country is over (under)- adjusting relative to the European benchmark (the origin). The Figure clearly shows the Virtuosi and the Laggards. Among the former, Belgium (with an excess adjustment between 1.5 and 1.8 points of GDP in 2010-15), the Netherlands and Germany (+ 0.4 – 1 percentage points) and, somewhat surprisingly, Portugal (+1 – 1.9%), Spain (+ 0.8-1.3 %), and Greece (+ 0.7 points of GDP). The UK is roughly in line with the EU average (when Greece is excluded) and appears as “Virtuoso” (+ 1.8 points) when Greece is included in the exercise. Ireland appears here as a Laggard simply because budget cuts have occurred before 2010 and are not counted here. There are two small and one big Laggard. The small ones are Austria, whose adjustment falls below the benchmark by roughly half of a percentage point, and Slovakia (- 0.8 -1.4). The “Big Laggard” is Italy: at the current level of debt, primary and current account balances and unemployment rate, Italy would need extra cumulative fiscal cuts of 2.4 -2.7 point of GDP in five years, to be in line with European consolidation efforts.

Conclusions

The lessons from this exercise are the following: Greece, Portugal and Spain, which financial markets have singled out as the most vulnerable, have planned adjustments that other Europeans, at comparable fundamentals (but paying average spreads!) would not dream of. Germany and the Netherlands are the Virtuosi of the pack, but moderately so. Among high debt countries, Belgium is overdoing it, striving hard not to join the PIIGS’ club. Italy, the Big Easy, so far is getting away with it.